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Monday, April 29, 2013

Is Monetary Policy Capable of Offsetting Fiscal Austerity?

Mike Konczal has a new article where he claims there is a great natural experiment unfolding in the U.S. economy, one that Ramesh Ponnuru and I proposed back in 2011:

We rarely get to see a major, nationwide economic experiment at work, but so far 2013 has been one of those experiments — specifically, an experiment to try and do exactly what Beckworth and Ponnuru proposed. If you look at macroeconomic policy since last fall, there have been two big moves. The Federal Reserve has committed to much bolder action in adopting the Evans Rule and QE3. At the same time, the country has entered a period of fiscal austerity. Was the Fed action enough to offset the contraction? It’s still very early, and economists will probably debate this for a generation, but, especially after the stagnating GDP report yesterday, it looks as though fiscal policy is the winner.

So Mike Konczal's assessment of this experiment is that monetary policy has not been able to offset fiscal austerity. Paul Krugman agrees as do other observers who question the effectiveness of monetary policy in a liquidity trap. I agree that there is an interesting experiment going on, but Konczal and Krugman (K&K) oversell what it means and ignore other recent developments that shed light on the efficacy of monetary policy.

For starters, this experiment is only measuring whether QE3 is powerful enough to offset fiscal austerity. It is not measuring whether the actual proposal Ramesh and I laid out in 2011, a nominal GDP level target (NGDPLT), is capable of offsetting fiscal austerity. QE3 is a big change in Fed policy, but it is still far from a NGDPLT in terms of efficacy. One way to see this is to note that QE3 constrains asset purchases to a fixed dollar amount of $85 billion per month no matter how fast or slow the economy is converging to the Fed's inflation and unemployment targets. Consequently, if a spate of bad economic shocks--more Eurozone uncertainty, sequestration, China slowdown concerns, etc.--suddenly increased money demand the $85 billion injection may not be enough to offset it. In this case, aggregate demand would slow down and stall the convergence to the Fed's target.

QE3, then, is like taking a road trip and applying the same pressure to the gas pedal regardless of whether one is driving up a hill, down a hill, or on a flat terrain. The trip's length would depend on the changing terrain of the road (the shocks) and would be hard to know ahead of time even though you know your trip's destination (the target). This is better than taking a QE2 road trip, where you don't know your destination, but there is still much uncertainty about how long the QE3 trip will take. Now imagine you turn on cruise control at 70 MPH so that your car automatically adjusts the amount of gas based on the terrain. There would be much more certainty about the trip and much better expectations management. This would be much closer to a NGDPLT and provide the real test of whether monetary policy can offset fiscal austerity. It could be operationalized by conditionalizing the size of the QE3 asset purchases each month so that constant progress to the Fed's targets were being maintained. QE3, therefore, is farm from ideal and, as Matt O'Brien observes, it is not even clear the Fed is fully on board with it.

With that said, one can still learn a lot about the potential of monetary policy to offset fiscal austerity by looking at the fiscal consolidation in the United States over the past few years. As I have noted before, fiscal austerity has been happening in the U.S. economy since about mid-2010. And yet, the Fed has kept NGDP growing on a remarkably steady growth path (albeit, below its pre-crisis trend path). This performance is even more remarkable when you consider that there have been other negative AD shocks buffeting the U.S. economy. K&K ignore this achievement and its implications for monetary policy offsetting fiscal austerity.

Evan Soltas notes that further insights about monetary policy's ability to offset fiscal austerity can be gleaned by comparing the U.S. economy to the Eurozone economy over the past few years. Below are some figures that make this comparison. The first one compares government spending in both regions in absolute dollar and euro amounts. The figure shows that both regions experienced a similar flattening of government spending beginning around 2010. (Total federal expenditures actually decline in the United States. I couldn't find a similar measure for the Eurozone.)

If we now look at government spending as a percent of NGDP, we see that government spending's share has been falling in both regions. The U.S. decline has been the sharpest.

So we have two large economies experiencing fiscal austerity as seen above. Both are receiving the fiscal austerity 'treatment'. What effect is that treatment having on their NGDPs? The figure below shows the respective NGDP growth rates in both regions:

The U.S. series shows a stable NGDP growth rate of about 4%, consistent with the NGDP level figure linked to above. The Eurozone NGDP, however, shows a pronounced decline starting in 2010. So both regions have fiscal austerity, but only the United States has stable aggregate demand growth. The easiest explanation for the difference is monetary policies: the Fed has been far more aggressive than the ECB in responding to the slump. Yes, this is not definitive evidence, but it certainly is suggestive that monetary policy makes a big difference in offsetting fiscal austerity.

Update: A commentator correctly notes my first few graphs ignore the fiscal drag created by tax changes. So I grabbed the IMF's estimate of structural budget balances as a % of potential GDP and made the following figure:

While it does show a higher level
of fiscal austerity for the Eurozone, it also indicates the rate of
fiscal tightening is very similar in both regions. In other words,
fiscal consolidation is happening at a similar pace across the two
regions though they start from different points. Given this similarity,
one would expect to see some similarity in the NGDP growth rate graph since the tightening began in 2010.
But there is none. The gap, then, can still be explained by the
differences in monetary policy.

Your approach is good. Nominal GDP would reflect a more robust economy because inflation needs to rise. A higher inflation rate would bring the Fed rate into positive territory. Yet at the moment, inflation is being suffocated by a declining effective demand. It looks too late for the solution, which is raising labor share of income and unit labor costs. Aggregate profit rates are already stagnating, thus any move to re-balance aggregate supply and effective demand in the economy now, will probably just create a recession, instead of just a temporary contraction followed by a more robust economy. The economy is simply too sensitive due to effective demand being low. The government needs to do a fiscal stimulus or the end of the current expansion is in sight. Here is the explanation…http://effectivedemand.typepad.com/ed/2013/04/as-ed-model-raising-labor-share-of-income.html

I think its worth considering how Bernanke's comments about sequestration affected the expectations channel. I blogged about it here: http://southofthe49th.blogspot.com/2013/04/expectations-monetary-policy-and.html

David,Can you please state specifically which government spending series you have graphed (there are so many). I have been working with similar data for virtually identical reasons and wish to make comparisons. Incidentally I sent Evan Soltas some closely related graphs in response to his recent posts.

David, If you want to be consistent, U.S. "government final consumption expenditure" is also available at Eurostat and the OECD. FRED has the OECD series (series USAGFCEQDSNAQ) and I believe it is identical to Eurostat's.

It's also possible to come up with the Eurostat EA17 equivalent of "government consumption expenditures and gross investment" but it's rather involved. I found this helpful as a guide:

In particular read the section titled "Definition of general government expenditure." The bottom line is that they call gross investment "gross capital formation" (P5). All told there seems to be six items in consumption and investment: 1) P5, 2) intermediate consumption (P2), 3) compensation of employees (D1), 4) other taxes on production (D29, "payable"), 5) current taxes on income, wealth, etc (D5, "payable"), 6) adjustment for the change in net equity of households in pension fund reserves (D8).

It's rather cumbersome but I believe that is equivalent to the U.S. definition. One big problem is this data is not seasonally adjusted. I seasonally adjusted it using the Census X12 feature of Eviews. Or, if you're interested, I can just email you the final series.

There is still another consistent option but this one is relatively easy. Eurostat has "Total general government expenditure" which can be found in the "Quarterly non-financial accounts for general government". (It's also available in annual frequency.) This is available in seasonally adjusted form.

The BEA equivalent to "Total general government expenditure" is "Government total expenditures" which is found in Table 3.1 Line 33. or you can just go to FRED (series W068RCQ027SBEA).

There are still other options, but those are the three that I have been fiddling with.

Government spending is a very incomplete measure of fiscal policy stance. Making the graphs above worthless. Taxes matter too. Spain, Portugal, Greece, France, the UK and Italy have all increased taxes as well as cut spending during the crisis.

Anonymous,In particular if you compute the differences between the 2010 structural balance and the projected 2013 structural balance you will find the difference to be 3.9 points for the US and 3.2 points for the EA17.

In fact the only EA17 members that are projected to increase their structural balance more than the U.S. between 2010 and 2013 are Greece (11.8), Portugal (6.1) and the Slovak Republic (4.3). This of course means that the U.S. is projected to have done more fiscal consolidation over this period than Spain (3.5), Italy (3.4) and Ireland (3.3).

David,Another measure you might consider is the "cyclically adjusted primary balance". This excludes the interest on government debt. You can find it in the IMF Fiscal Monitor (the latest edition only just came out). The results are very similar, with the advantage that they will be even more convincing to sceptics. For example between 2010 and 2013 the US and the EA17 are projected to increase their cyclically adjusted primary balances by 4.0 and 3.8 points respectively. So even by this measure the US will have done more fiscal consolidation than the EA17.

It is particularly sad when politicians can find out only after the fact that their policy had been ill-suited to the economic condition of their time. More sad still is when those politicians continue on, in denial,even as the verdict is coming in. For more analysis, pls see my essay at http://www.thewordenreport.blogspot.com/2013/04/does-austerity-work.html